Sunday, June 27, 2010

Accor's Spin-off Edenred: Business Analysis & Valuation

Accor (AC on Euronext Paris) is a French multinational corporation that is a European leader in hotels (Accor Hospitality) and a global leader in corporate services (Accor Services). Accor Hospitality, the Accor hotel branch, has more than 4000 hotels worldwide, ranging from economy to luxury. Through Accor Services, Accor runs service vouchers to over 490,000 companies and institutions worldwide and 33 million users in 40 countries.

In 2009, the company embarked on a major strategic project to demerge its two core businesses, Hotels and Services. The demerger is planned for July 2, 2010, subject to a shareholder approval on June 29, 2010. In this article, I discuss the business and valuation of the Services unit.

Business Overview
The Services unit (to be renamed as Edenred upon demerger) is in the business of providing prepaid services to business and customers. It is the global leader in one of its segment (prepaid benefits products and services) and a leading player in the other segment (prepaid performance improvement products and services). Its business model is one that generates lots of free cash without requiring much capital investment. Here is how it works:

Companies and public authorities purchase vouchers from Edenred at face value plus a service commission and distribute them to the beneficiaries (generally employees). The beneficiary uses the vouchers at face value to purchase goods and services from affiliated merchants (such as restaurants), which in turn redeem the vouchers. Upon redemption, Edenred pays the merchants the face value of the vouchers, less a redemption commission. Between the time the customers pay for the vouchers (most of which are prepaid) and the time the affiliated merchants are reimbursed, the funds (also known as float) are invested and generate financial revenue. To summarize, its total revenues from vouchers include (i) service and redemption commissions, (ii) financial revenue and, (iii) breakage revenue from lost and expired vouchers.

The products and services within the two segments that Edenred operates in are as follows:

  1. Employee and public benefits products and services:
    • Meal and food vouchers enable the employees from having lunch in a restaurant or similar food service establishment of their choice. Employers pay for all or part of the cost of these vouchers, and the amount that the employers pay is tax deductible. The benefit to the employee is tax free. Also, all or part of the face value of the vouchers is exempt from social security contributions for the employer and the employee. 
    • Non food benefits include vouchers that allow employers to pay all or part of the cost of childcare services , household employees, and transport.
    • Public Benefit programs include vouchers that help local authorities and public institutions distribute social aid as per their policy.
  2. Prepaid services to improve performance of organizations:
    • Expense management vouchers enable companies to monitor and control employee business expenses. One of the main products in this category is car voucher which allows employees to purchase fuel for business related traveling.
    • Incentives and rewards include products like gift vouchers.
Since the meal and food voucher volume is dominant, I want to describe this product in further detail. Meal vouchers have been around since the 1950s. The meal vouchers came in existence to provide an equalizing effect for the smaller companies. These companies, unlike the larger ones, could not afford to give meal benefits to their employees through a cafeteria of their own. Also, the larger companies that maintained a cafeteria did so because of the tax benefits associated with it. Governments recognized this as an issue and enacted the tax laws to incentivize the smaller companies to provide meal benefits to their employee through meal vouchers. There were obvious economies of scale to outsource the maintenance of such a meal voucher program, and hence the meal voucher industry. 

But, why would a government let go of tax revenues and subsidize such a meal voucher program. There are a few good reasons for doing so. There is evidence that meal vouchers boost the local food and restaurant businesses, thereby creating more jobs, and causing multiplier effects. Also, in countries like Brazil, where majority of the transactions in the retail business are on a cash basis, substantial tax revenues are lost because of unreported revenues to tax officials. Meal vouchers help to move the "informal" economy to a formal one. Thus, the cost of subsidizing the meal vouchers are often offseted. (Fore more information, refer to "Food at Work" listed in the references section).

Competitive Advantages
Edenred is a global leader in the benefits segment with Sodexo being the only other international player in this segment. However, both face some level of competition from local players in each of the markets that they operate in.

The name of the game in the voucher business is issue volume. The higher the issue volume that a particular player has, the wider is its "moat". For obvious reasons, merchants want to accept the vouchers of the top three to four players (by volume). So, most corporate customers want to use one of the three to four larger players (by merchant coverage network). Hence, the network effect. If a smaller player tries to grow its issue volume by cutting down fees, the top players will match the "discount" in fees temporarily in order to dominate in issue volume, and hence throw the smaller player out of the game. Thus, there are very large barriers to steal market share from the larger players. Also, the larger players are sensible enough not to kill each other in a race for market share from each other.

However, the situation in the performance products segment is very competitive. There are many other providers in this business - prepaid solutions specialists, retail banks, payment processing companies, and other program managers like Edenred. Having said that, Edenred has a strong position in expense management products in the countries it operates in (Brazil and Mexico) and so some of the same dynamics described above apply to this product category too. For the other products in this category, the market is fast growing and hence could leave room for Edenred to have market share.

Financial Data
Issue Volume and Revenue:
Issue volume has grown at a 6.8 billion euros in 2003 to 12.4 billion euros in 2009). Even in the recession of 2009, issue volume grew by 5.7% (without accounting for non-recurring impact of Venezuela's currency devaluation).

The 2007-2009 data shows that operating revenue (without contribution of financial revenue from float) as a percentage of issue volume was very stable. 

Issue Volume to Cash Flow Conversion Ratio:
Edenred's business model is a cash flow generating machine. The example below is based on very conservative data from 2009 when unemployment was high and interest rates were low:

Not all the float generated is available to the enterprise. Regulations in certain countries requires that the float be maintained as a separate trust account (called restricted funds), so these funds are not accounted for under free float. These regulations are for France, Hungary and UK and account for 565 million euros.

Historical Free Cash Flow:
Funds from Operations (FFO) has grown 46 million euros in 2003 to 184 million euros in 2009.

To calculate cash flow from operating activities (CFO), we add the variation of float from one year to the next to FFO. Subtracting the capex from CFO gives the free cash flow available to shareholders (FCFE). Shown below is the FCFE data for 2007-2009.

For the sake of this article, I will focus on the risks that can cause permanent impairment of business.

1) Changes in laws and regulations governing special tax treatment of Edenred's employee and public benefits products and services:
The employee and public benefit products and services account for 88% of the revenue. Changes in laws and regulations can have a significantly adverse effect on issue volume. As an example, lets use UK and Argentina as an example. Meal vouchers were invented in UK in the 1950s. The tax exemption was set to 15 pence and it was enough to buy a meal then. However, this tax exemption has never been increased, and as a result there are very few participants in the meal voucher system (0.3% of workforce compared to 80% of workforce in Hungary). This shows that tax incentives play a massive role in the sustainability and growth of the voucher business. Recently, Argentina abolished the special tax treatment for vouchers causing a 63% drop in issue volume in 2009. With growing deficits, governments around the world are under constant pressure to grow tax revenue. It is possible that the special tax treatment for the voucher may become a target. Having said that, Edenred's CEO, Jacques Stern, in a recent investor day presentation gave some insight into how to think about this risk. (i) The meal voucher system benefits a mass majority of people, not a special group. Usually, governments target tax exemptions that benefit a special group. Also, a government that is considering such changes faces headwinds from all the stakeholders - unions, employers, voucher providers. (ii) The meal vouchers have shown to cause multiplier effects in the economy. Currently, the reverse of these effects are being experienced in Argentina as a result of meal vouchers being abolished.


2) Transition to electronic format
This could cause a loss in financial revenue due to compression of time lag between issuance and redemption of vouchers. Also, it could cause a loss in breakage revenue of vouchers. However, we can take Brazil as an example where vast majority of the products have transitioned to the electronic format. This has caused issue volume to up, operating costs to come down (due to economies of scale), and added a few new sources of fees that are unique to the electronic card model. So, as per the management team, this risk is not a major threat.

Future Strategy
The management team has set forth 4 key drivers for growth in issue volume of 6-14% (normalized growth rate at local currency level).

The management team will also be selectively looking to do acquisitions to boost growth. In 2007, the firm acquired a B2C gift rewards business (Kadeos). The B2C business is not Edenred's competitive strength and is extremely competitive. In 2009, they wrote down 100 million euro for this acquisition. The CEO Jacques Sterns in the investor day presentation commented about staying within their core strengths moving forward. I think they have learnt this lesson well, and will probably not goof up by paying up for another acquisition.

There are at least two ways to value the business. 
  1. Using a price/cash flow multiple from a comparable business
  2. DCF analysis of free cash flow based on various growth scenarios
There are no other public pure players in the same industry as Edenred. Other businesses that are closest to Edenred in terms of business model are ADP and Paychex Inc. Based on the valuation below, the most likely value of the Edenred business (per share) is in the range of 22-28 euros. In the highly unlikely worst case scenario, it is worth at least 16 euros. I have used a conservative terminal value of 2% growth in FCFE based on average worldwide GDP growth and discount rate of 10% due to its wide moat medium risk business. For Edenred's P/CF multiple, I calculate the CF from FCFE using the more conservative projected capex rather than historically lower capex. Also, using ADP and Paychex P/CF multiple gives Edenred the same valuation range as the DCF analysis.

Management and Majority Shareholders
In 2005, real estate private equity firm Colony Capital along with European firm Eurozeo took a large position in Accor. Today, together they own 30% of the company. Also, a new CEO, Gilles Pellison, was brought in to manage Accor. Also, Mr. Pellison happens to be the nephew of Accor's original founder. The founding family and directors jointly own about 2.7% of the company. Southeastern Asset Management owns about 7% of the company through its International Fund. (Scott Cobb, one of the managers of the the international fund, spoke extensively on Accor at its latest shareholder meeting). Edenred's CEO Jacques Stern was first the CFO of Accor and is a superb executor. In conclusion, the management team, the Board, and the large shareholders have their interests aligned.

  1. Proposed demerger of the two businesses, Gilles Pellison, Accor
  2. Edenred's supplement to the prospectus, June 11, 2010, Accor
  3. Investor Day Presentation May 15, 2010, Accor
  4. Annual reports 2005-2009, Accor
  5. Food at Work: Workplace solutions for malnutrition, obesity, and chronic diseases. Christopher Wanjek. International Labor Office, Geneva.
  6. Scott Cobb on Accor, Longleaf Funds Shareholder's meeting 2010.

Disclosure: The author owns a long position in Accor (AC.PA) and plans to participate in the spin-off of Edenred (if there is enough margin of safety). This is not a recommendation to buy or sell any security. This presentation is for information purposes only. Do you own research before taking any action regarding any security mentioned in this article.


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